HUNTING IN THE Enchanted FOREST: The Search for VC-Backed Treasures

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By Bailey McCann

ILLUSTRATION BY Davide Bonazzi

Late-stage, high-growth companies have been awash in easy money and easy exits for many years. But the market has changed and so have the incentives.

Market headwinds have already hit dealmaking and valuations to an extent, and venture capital is no exception. While conditions are expected to worsen somewhat in the coming year, this could spell opportunity for private equity firms looking for late-stage startups.

The exit environment for VC-backed companies remains challenging, with only one exit for every 15 investments on average, according to data from PitchBook-NVCA Venture Monitor. If companies were taking on venture capital financing with an eye toward an initial public offering, that window is closed. Exits to strategics or startup-tostartup M&A deals, which had been on the rise in late 2021, have also slowed significantly.

Against this backdrop, many late-stage startups are pausing to evaluate their options, but that could change over the next year and a half.

Shawn Flynn, a San Francisco-based principal at financial intermediary Global Capital Markets, notes that many of the companies that made strategic pivots last year—or put capital raising activities on hold while they reinforced their balance sheets—will likely come to market over the next 12-18 months. If these companies can tell a positive story, they’ll find eager sponsors with money to put to work—and there’s plenty of capital out there.

“I spoke to a private equity firm recently that wanted us to bring them companies that couldn’t raise their next VC round or were holding off because they were anticipating a down round as a result of the market,” Flynn says. “I think some of these firms recognize that there’s an opportunity to invest in companies that are doing well but are getting caught up in broader macro headwinds.”

Private equity funds that have been big players in the tech space, including Thoma Bravo and Francisco Partners, have recently raised new funds to pursue targets, suggesting that demand might come back over 2023 and beyond if market conditions normalize and late-stage companies can show resilience through tighter liquidity conditions.

In July, Francisco Partners raised $17 billion across two funds. In December, Thoma Bravo raised $32.4 billion split across three buyout funds. Vista Equity Partners, another big player in the space, is in the market, too, targeting $20 billion for its latest flagship growth fund. The Carlyle Group also recently closed a tech investing fund on $3.12 billion. Meanwhile, growth equity firm JMI Equity closed its 11th flagship fund at $2 billion last year, shortly after raising $1.7 billion for its 10th fund focused on growth equity investing.

Each of these funds is on the hunt for mature and maturing high-growth companies with strong balance sheets.

An Ecosystem Realigns

Last year was characterized by market volatility, but it also clarified which types of sponsors have staying power in the pipeline of late-stage VC backing to growth equity support to private equity investment. In recent years, a large ecosystem of capital has formed around later stage companies, as sky-high valuations drew unicorn hunters from all corners of the investing universe.

Larger traditional private equity firms established growth equity teams to get in on the action. With the amount of capital that private equity has raised over the past several years, deal teams were looking for targets anywhere they could find them. Nontraditional sponsors—including hedge funds, family offices and some mutual funds—tried to capitalize on late-stage, venture-backed companies that were near their initial public offering in an effort to catch the pre-IPO premium. But in 2022, that fell apart.

Many of these newly listed companies took significant hits to their share prices as equities markets dropped in value. On top of that, the window for new listings is fully closed, effectively ending the pre-IPO premium pipeline—at least for the time being. As a result, late-stage companies must determine if they want to wait or try to position themselves as a target for the veteran growth equity and private equity firms that are still doing deals.

Gene Yoon, a New York-based managing partner at private equity firm Bregal Sagemount, says that the late-stage market is in a holding pattern. “Companies that have positive cash flow with a durable business model are obviously the types of companies we try to pursue, and they are the companies that are going to get the most interest from private equity in general,” he explains. “There’s a very specific subset of companies where valuations have remained high precisely because they are so well positioned.” last year, according to PitchBook’s report. Looking more closely at the data, valuations of companies that have positive cash flow or that have been able to bootstrap are proving to be more durable. But late- stage companies that are primarily reliant on venture capital are having a harder time if their path to profitability or breakeven is less clear.

Data from PitchBook and conversations with sources point to sectors like healthcare, clean tech, software and business services as ones where valuations and private equity interest are holding up the most. Sponsors want to see strong companies in general in this environment, but they are also looking for businesses in sectors that will be resilient in a recession. Companies that tick both boxes are likely to have the most power in negotiations with growth equity or traditional private equity firms.

Bregal’s Yoon says that deal teams, private capital lenders and even nontraditional sponsors are taking a much closer look at company quality than they have in the past.

“Where you’re seeing the most pain is companies that aren’t cash flowing yet,” he explains. “Those might not be bad companies, but there’s a lot of focus on how to clean them up and get them to at

Yet those businesses might not be interested in selling, especially if their founders don’t feel like they can attract the highest possible price. In those instances, eager investors will need to wait a little longer to seal the deal.

“We have to stay engaged,” Yoon says. “We try to understand where they want to go in the future, but it could be a few years before you see some of those companies pull the trigger.”

Sifting For Quality

When looking for venture- backed companies, private equity firms are likely to drill into the details and search for growth potential. Valuations for late- stage companies were down least a break-even point pretty quickly. If a company is reliant on VC funding, for example, they might be spending the next handful of months figuring out how to get to a more stable position. If they can’t do that, it’s probably going to be tough for them to continue.”

However, there might be some leeway for companies that have fallen victim to a challenging environment.

According to Flynn, these VC-backed companies are looking at a variety of scenarios as they decide what to do next. In many cases, private equity sponsors are willing to be flexible if both sides can come to an agreement.

“We’re seeing more companies where the board is advising them that they should look at how they are going to get through the next 12-18 months,” he says. “Before this year, everything was equity, equity, equity. Now we’re hearing more about raising debt or debt/equity hybrid options. Alongside that is a conversation about whether it makes sense to try to bring in private equity sponsors to help take a company to the next level. A lot of what we’re seeing right now is different groups building up their pipelines for the next year or two.”

Minority Stakes And Other Options

In some cases where late-stage startups are holding off on selling a control position until market conditions improve, private equity firms are pursuing growth stakes as a way of positioning themselves to take advantage of opportunities down the line. For example, in October, Francisco Partners invested in Acoustic, a brand experience provider for business-to-consumer brands alongside existing private equity investor Centerbridge Partners. The company says it plans to use the investment to continue growing its technology and brand experience platform.

Larry Contrella, a Baltimore-based general partner at JMI Equity, says his firm has had success with taking minority positions and building relationships with companies over time.

“We want to be strategic partners, so if there’s an opportunity to take a 20% stake, we’ll do that. If there’s an opportunity to take an 80% stake, we’ll do that,” he says. “Companies are really thinking through what they need most right now.” For some, that might mean a smaller liquidity event initially, while other companies recognize they need a partner that’s experienced in scaling businesses. “We have taken the position of being willing to offer a variety of ways to help them get where they want to go,” Contrella says.

Many of the traditional buyout firms that have added growth equity teams in recent years continue to pursue buyout-for-control deals, but Contrella notes that the dynamics of those transactions are different than growth equity. And they may be a tougher sell in this environment. “I’d almost call them lower mid-market buyout deals,” he says.

While many of the strategies these teams bring to the table could look like growth equity, in the end it’s still a control deal. If firms are pursuing companies where the founder doesn’t intend to exit, they may have to lean heavily on highlighting their ability to help companies scale, for example. Typically, entrepreneurs aren’t willing to become employees as they often do in traditional buyouts—even if there is a large liquidity event available to them after a few years.

Green Shoots

Contrella says despite some of the hits venture capital has taken, there is still likely to be significant competition for deals going forward. “There is a lot of money raised to invest in high-growth companies, and that’s going to keep demand high,” he says.

Despite questions around valuations, the cost of capital or the best time to sell, Contrella expects the attractiveness of fast-growing companies will outweigh those factors. “This is an area where a lot of sponsors want to be because there are a lot of good, defensible businesses with a lot of upside potential,” he says.

There will also likely be a new crop of startups that emerge from the layoffs and resignations roiling large technology businesses, which could one day become investment targets in their own right, adds Global Capital Markets’ Flynn.

“A lot of people had jobs in big tech and were also working on their own projects on the side,” he says. “Then the pandemic hit, and those side projects got more attention. Now these big companies are saying, ‘Come back to the office,’ and you’ve got a lot of very talented people whose stock options aren’t worth what they once were, who don’t want to be back in the office.”

Some of those individuals are leaving their companies and focusing on their own ventures, according to Flynn. Those businesses could one day enter the private capital pipeline and become interesting candidates for private equity. “There’s going to be a lot of fresh talent out there bringing new ideas to the table,” he says. //